What is Chapter 7 Bankruptcy?

While not required, the U.S. court system encourages individuals and businesses to hire a bankruptcy attorney who can help ensure they follow the proper rules and correctly fill out the necessary forms.Credit: zimmytws | Shutterstock

Named after the chapter that outlines it in the U.S. Bankruptcy Code, Chapter 7 bankruptcy is one of the most common types for individuals.

Chapter 7 bankruptcy is designed to give individuals buried in debt a fresh start financially. The process cancels many, or sometimes all, of an individual's debts. Specifically, it can eliminate certain unsecured debts, which are those where no collateral was put up, such as credit card and medical bills. In the process, the bankruptcy trustee — who represents the creditors during the case — can also collect and sell any accessible assets from the debtor, with any proceeds raised being used to pay some of the built-up debt. For that reason, the Chapter 7 process is generally recommended for individuals with little no or non-exempt property.

Property that debtors can often keep when filing for Chapter 7 bankruptcy includes cars, homes, clothing, household goods and appliances, pensions and tools needed for the debtor's profession. Property that can be seized and sold during this type of bankruptcy includes family heirlooms, collections of stamps, coins or baseball cards, and a second car or home. Statistics show, however, that 85 percent of Chapter 7 bankruptcy cases involve debtors who have no non-exempt assets to part with.

Under the current bankruptcy laws, which were enacted in 2005, only individuals who earn less than the median income in their state are automatically eligible to file for Chapter 7 bankruptcy. Those who earn more are required to pass a "mean test" designed to force high-income debtors into filing for a separate type of bankruptcy that requires more of the debt to be paid off. By the end of the process, which is conducted in the federal court system's Bankruptcy Court, all of the individual's debts are discharged, which prevents the parties who are owed those debts from taking any collection actions against the debtor.

According to the United States Courts, there are certain instances for which a discharge of debts may not be granted, including when the debtor failed to keep or produce adequate books or financial records; failed to explain any loss of assets; committed a bankruptcy crime such as perjury; fraudulently transferred, concealed or destroyed property that would have become property of the estate; or failed to complete an approved financial management education class.

Chapter 7 vs. Chapter 13

The main difference between filing for Chapter 7 bankruptcy and filing for Chapter 13 bankruptcy is that no payment plan is devised. In Chapter 13 bankruptcy, the debtor and bankruptcy court agree to a plan to repay a portion, or all, of the outstanding debts. In Chapter 7, there is no repayment plan because certain debts are eliminated altogether. Another major difference is the length of time it takes to complete the process. While Chapter 7 bankruptcy proceedings can be completed in six months, the Chapter 13 process takes substantially longer. The Chapter 13 process is not completed until the payment plan is finished, which can take as long as five years. Additionally, debtors who file for Chapter 13 bankruptcy don't risk losing any property or assets, since they are using their income to fulfill their payment plan obligations.

Chapter 7 vs. Chapter 11

While Chapter 7 bankruptcy is mainly used by individuals and referred to as liquidation bankruptcy, Chapter 11 is typically used by businesses and known as reorganization or rehabilitation bankruptcy. While it was originally intended only for large businesses, individuals can now file for Chapter 11 bankruptcy. Similarly to the differences between Chapter 7 and Chapter 13, Chapter 11 differs from liquidation bankruptcy in the fact that the debtor's assets will not be sold off as part of the payment process. Also under Chapter 11, an individual's or business' debts are not negated as they are under Chapter 7. Instead, the terms of the loan are altered to make it easier for the debtor to pay it off. As with Chapter 13, debtors who file for Chapter 11 put together a three- to five-year repayment plan. In addition, filing for Chapter 11 bankruptcy is much more complex and costly than Chapter 7 proceedings.

Filing for Chapter 7 bankruptcy

The first step to filing for Chapter 7 bankruptcy is to attend a credit counseling class. Those who file for bankruptcy must attend and complete a credit counseling class prior to filing for bankruptcy. Once the class is finished, the individual or business can file a Chapter 7 bankruptcy petition with the bankruptcy court that serves the area where they live or where their business is located.

While not required, the U.S. court system encourages individuals and businesses to hire a bankruptcy attorney who can help ensure they follow the proper rules and correctly fill out the necessary forms. In addition to the bankruptcy petition, the debtors must provide the court with a host of other financial information, including a list of their assets and liabilities, a schedule of current income and expenditures, a statement of financial affairs and a copy of the most recent tax returns.

As soon as the petition is filed, an automatic stay is enacted, whichstops most collection actions against the debtor or the debtor's property. As long as the stay is in effect, creditors are not allowed to file or continue lawsuits, try to garnish wages or call the debtor demanding payments. After the filing, the debtor is required to attend a meeting with the case's bankruptcy trustee, an impartial trustee who administers the case and liquidates the debtor's nonexempt assets. During the meeting, commonly known as a "341 Meeting," the debtor is required to truthfully answer questions about their assets and liabilities.

The creditors then have 60 days to object to the bankruptcy. If no objections occur, the courts discharge the debts, meaning the debtor is no longer responsible for them. Debtors should be aware, however, that not all debts can be wiped out by filing for Chapter 7 bankruptcy. According to the U.S. Courts, bills that a debtor is still responsible for include debts for alimony and child support, certain taxes, debts for certain educational benefit overpayments or loans made or guaranteed by a governmental unit, debts for death or personal injury caused by the debtor's driving under the influence of drugs or alcohol and debts for certain criminal restitution orders. Once the discharge of the debts is complete, the individual or business can start the lengthy process of rebuilding their credit and financial standing.